Taxes

Also called: Taxation · Topic: Taxation: Direct and Indirect Taxes, GST and Global Tax Issues · NCERT: Class 7, Ch 8 "Banks and the Magic of Finance"; Class 9, Ch 8 "Building Blocks in Economics: The Problem of Choice"; Class 9, Ch 9 "The Price Puzzle: What Drives the Market"; Class 10, Ch 2 "Sectors of the Indian Economy"

Meaning

A tax is a compulsory payment that people and firms must make to the government under a law. It is unrequited: the taxpayer gets no specific service back in return. The government uses this money for services everyone shares, such as defence, police, roads and schools.

Taxes are the government's main source of revenue. Their design also decides who carries the burden (equity) and how much the economy swings between boom and slump (stabilisation). A simple proportional tax is written as T = tY, where t is the tax rate and Y is income.

Explanation

What makes a payment a "tax"

• It is compulsory. You cannot refuse to pay it.
• Nothing specific comes back to you. You pay income tax, but you get no particular service in exchange.
• It needs a law. In India, Article 265 says: "No tax shall be levied or collected except by authority of law." [2]
• Parliament or a State Legislature must pass the law.

• An executive order alone cannot impose a tax.

• Test to tell a tax from a fee:

• If a direct service comes back to the payer, it is a fee. A passport fee and a court fee are examples.
• If nothing specific comes back, it is a tax.
• Fees and charges count as non-tax revenue.

Canons of taxation (rules for a good tax)

• Adam Smith's four canons (Wealth of Nations, 1776):

Canon	Simple meaning	Indian example
Equity	People pay according to their ability to pay	Income-tax slabs: higher income, higher rate
Certainty	The amount, the time and the way of paying are clear	Rates and due dates are fixed in the Finance Act
Convenience	Tax is collected at a time and in a way that suits the payer	TDS (tax deducted at source) is cut from salary; GST is paid inside the purchase price
Economy	Collecting the tax costs little	Online filing keeps collection costs low

• Canons added by later writers (these are not Smith's):
• Productivity: the tax should raise enough money to be worth levying.
• Elasticity: revenue should rise on its own as income rises, without any new law.
  • Worked example: GDP grows 10% and tax revenue grows 12%. Revenue is growing faster than income, so the system is elastic.
  • A progressive income tax is naturally elastic. As incomes rise, people move into higher slabs.

Direct vs indirect taxes

• Three key words:
• Impact: falls on the person the law makes pay the tax.
• Incidence: falls on the person who finally bears the money burden.

• Shifting: passing the burden on to someone else, usually through higher prices.

• Direct tax: impact and incidence fall on the same person.

• NCERT: "taxes on incomes of individuals, as well as, profits of business enterprises".
• Examples: personal income tax, corporation tax (tax on company profits), capital gains tax (tax on profit from selling shares or land), MAT (Minimum Alternate Tax, a minimum tax on a company's book profit) and STT (Securities Transaction Tax, a small tax on each share trade).

• It can be made progressive.

• Indirect tax: the burden can be shifted through prices.

• NCERT: "taxes levied on goods and services".
• Examples: GST, customs duty, excise duty and the Social Welfare Surcharge (an extra tax calculated on customs duty).

• It is generally regressive.

• How GST gets shifted:

• The shop pays GST to the government, so the impact is on the shop.
• The shop adds GST to the bill, so the buyer pays more.
• The incidence therefore falls on the final consumer.

Rate structure and form of tax

• Progressive tax: the rate rises as income rises. India's income-tax slabs are the main example. NCERT calls it the government's main tool for redistribution (moving income from rich to poor).
• Proportional tax: one flat rate at every income level.
• Regressive tax: takes a larger share of a poor person's income than a rich person's. A poll tax (the same amount per head) is the textbook example.
• Why indirect taxes are regressive
• NCERT's reason ("they impact all income groups equally") is loose. The real reason is that poor households spend almost all their income, while rich households save part of theirs.
• Worked example with 10% GST:

Household	Income (₹)	Consumption (₹)	GST paid (₹)	GST as % of income
Poor	10,000	10,000	1,000	10%
Rich	1,00,000	60,000	6,000	6%

• The rich household pays more rupees but a smaller share of its income.

• Ad valorem vs specific tax

• Ad valorem means a percentage of the price. With 18% GST, a ₹100 item pays ₹18 and a ₹200 item pays ₹36. Revenue rises with prices, so it is inflation-proof.

• Specific means a fixed amount per unit. A ₹10 per litre duty stays ₹10 whether petrol costs ₹90 or ₹110. It is easy to calculate and hard to evade by under-stating value.

• Proportional tax and the multiplier (the multiplier is how much total output rises for each extra rupee of spending):

• Disposable income (income left after tax) = (1 − t)Y.
• MPC (the marginal propensity to consume, the share of each extra rupee people spend) falls from c to c(1 − t).
• Multiplier = 1 / [1 − c(1 − t)]
• NCERT example: c = 0.8 and t = 0.25, so c(1 − t) = 0.6 and the multiplier = 1 / 0.4 = 2.5.
• With a lump-sum tax (a fixed amount not linked to income), the multiplier = 1 / (1 − 0.8) = 5.

• So if government spending rises by ₹100 crore, output rises by ₹250 crore under the proportional tax and by ₹500 crore under the lump-sum tax.

• Why this makes the tax an automatic stabiliser:

• In a boom, incomes rise, so the tax paid rises on its own.
• People have less extra money to spend.
• Swings in output become smaller, and no new government decision is needed.

In India

• Legal basis: Article 265 ("Taxes not to be imposed save by authority of law"). Every tax needs a law behind it. [2]
• Yearly rates: tax rates and due dates are fixed each year in the Finance Act, which serves the canon of certainty.
• Collection tools:
• TDS takes tax at the moment of payment (convenience).

• GST is collected along with the price of goods and services.

• Direct tax collections, FY 2024-25 (up to 17 June 2024, provisional):

• Net direct tax collections: ₹5,15,986 crore. [3]
• Corporation tax: ₹2,26,280 crore. Personal income tax including STT: ₹2,88,993 crore. [3]

• Gross direct tax collections grew 20.99% over the same period a year earlier. [3]

• Union Budget 2025-26 (Budget Estimates):

• Gross tax revenue is budgeted to grow 10.8%. Taxes on income are budgeted to grow 14.4% and corporation tax 10.4%. [4]
• GST: ₹11,78,000 crore, made up of CGST at ₹10,10,890 crore (86%) and GST compensation cess at ₹1,67,110 crore (14%). [4]

• Total indirect taxes: ₹17,35,100 crore. [4]

• National accounts: taxes connect GVA (gross value added, the value of output minus the inputs used up) to GDP.

• GVA at factor cost + net production taxes = GVA at basic prices.
• GVA at basic prices + net product taxes = GDP at market prices.

• NCERT data for 2024-25 (constant prices): GVA at basic prices ₹1,71,87,446 crore + net taxes ₹16,09,509 crore = GDP ₹1,87,96,955 crore.

• Global benchmark: the OECD average tax-to-GDP ratio (total tax as a share of GDP) rose to 34.1% in 2024. The range ran from 18.3% (Mexico) to 45.2% (Denmark). [5]

Don't confuse with

• Fee / user charge: a fee buys a specific service, such as a passport fee. It is non-tax revenue. A tax gives nothing specific back.
• Impact vs incidence: impact is on the person who legally pays. Incidence is on the person who finally bears the burden. They are the same for direct taxes but can differ for indirect taxes.
• Product taxes vs production taxes: product taxes (GST, excise, customs) are paid per unit of output. Production taxes (land revenue, stamp and registration fees) are paid whatever the volume of output.
• Ad valorem vs specific: ad valorem is a percentage of value (18% GST). Specific is a fixed amount per unit (the old ₹400/tonne coal cess).

Prelims Hooks

• Article 265: no tax can be levied or collected except by authority of law. An executive order alone is not enough. [2]
• Adam Smith's four canons (1776) are equity, certainty, convenience and economy. Productivity and elasticity were added later. They are not Smith's.
• STT and MAT are direct taxes. Customs duty and the Social Welfare Surcharge are indirect taxes.
• Fees, interest, dividends, profits and foreign grants are non-tax revenue. A passport fee is not a tax.
• Multiplier with a proportional tax = 1 / [1 − c(1 − t)]. For c = 0.8 and t = 0.25 it is 2.5, against 5 under a lump-sum tax.
• A poll tax is the textbook regressive tax. Stamp duty and land revenue are production taxes, while GST and excise are product taxes.

Mains Points

• Equity vs efficiency in India's tax mix
• Indirect taxes are easy to collect: GST is budgeted at ₹11,78,000 crore (BE 2025-26). [4]
• But they take a larger share of poor households' income.

• Shifting the mix towards progressive direct taxes serves equity and elasticity. Consumption taxes serve convenience and economy.

• Taxes as an automatic stabiliser and a rule-of-law issue

• A proportional or progressive tax lowers the multiplier (2.5 against 5 in NCERT's example). This softens booms and slumps without new decisions and supports counter-cyclical fiscal policy (policy that works against the business cycle).

• Article 265 ties every levy to a law. [2] Retrospective amendments (changing tax rules backwards in time) break the canon of certainty and hurt investor confidence.

• Widening the base, not only raising rates

• OECD countries averaged 34.1% tax-to-GDP in 2024. [5]
• India can raise its ratio by getting more people and firms to pay tax, using TDS, GST invoice-matching and simpler slabs. This raises productivity without hurting the canon of economy.

Related concepts

• Direct tax
• Indirect tax
• Ad valorem and specific tax
• Progressive taxation
• Proportional tax
• Regressive tax

Read more

• Taxes: meaning, canons and classification